Wednesday, August 31, 2011

We have to give Bill Gross some credit for admitting his mistaken call on the U.S. Treasury market; see here.

Gross's call was based largely on the fact that the Fed's Treasury purchase program was about to expire. The idea is that with a large component of the demand for Treasury debt removed from the market, bond prices should fall once the program is terminated.

This is what you get when you apply the static Marshallian scissors toward understanding an economic phenomenon. It often works well. But not always. And in any case, we know that forecasting the path of security prices is a tricky business. This is what the efficient markets hypothesis tells us.

Gross's intuition was shared by a few of the macroeconomists I bumped into earlier this year at a macro conference in Konstanz. I remember one of my Fed colleagues and myself suggesting to a sceptical audience that one should not expect any dramatic bond price movement once the Fed's purchases ended, largely because the market had already discounted that event. I don't think we were very successful at persuading people. Well, we turned out to be right about that (maybe we got lucky). [Actually, I did give my view of Gross' predictions here in March 2011].

Subsequently, of course, the price of US Treasuries have risen substantially. We did not make that prediction (nor did we try). But evidently, Paul Krugman seems to think he did; see Who You Gonna Bet On?

Yep. All we need is the Econ 101 macro model to understand this crisis and predict bond prices. (Oh, and gold prices have shot up too...where do those appear in that model?)

Do we really need an IS-LM model to tell us that when two assets with similar risk properties and similar returns are swapped in the Fed's portfolio that nothing much is likely to happen? (And as I explain here, standard monetary models deliver "flight to quality" phenomena quite easily.)

Krugman's article gives the impression that simple IS-LM analysis could have predicted the recent fall in Treasury yields. Do people actually find this credible?

Monday, August 29, 2011

A classic question in the theory of money is how an intrinsically useless object like fiat money can possess exchange value. The modern theory of money has essentially settled on the answer first provided by Ostroy (1973). In a nutshell, circumstances may dictate that some objects are relative good for record-keeping purposes, quite apart from any other use they may have in consumption, production, or storage; see also, Kocherlakota (1998).

The basic idea is as follows. We know that monetary exchange is not necessary, even in economies where mutually beneficial bilateral barter exchanges do not exist (what economists clumsily call a lack of double coincidence of wants). This is not simply a theoretical statement; we know of (and indeed most of us belong to) small economies (networks of families and friends) that operate according to "gift giving" principles. We are willing to make individual sacrifices without monetary compensation, hoping that they will be noticed, remembered, and most importantly, reciprocated at some point in the future.

Gift-giving societies seem to work well enough in small groups. This is probably because it is relatively easy to keep track of (remember) individual contributions and rewards in small groups. This "societal memory" seems to break down in large groups. Evidently, there are limitations to how much information can be recorded securely in the collective minds of people who make up society. When this is the case, some substitute form of memory could be useful. This is where money comes in.

Imagine that there is an object that is durable, divisible, portable, hard to counterfeit, and in limited supply. A lot of commodities fit this description, including gold, silver, and salt (think of what "salary" means). Historically, privately-issued paper in the form of asset-backed securities (like the banknotes of antebellum America) have also fit this description. In larger economies, objects like these begin to circulate as a means of payment. They become money.

Let me explain the basic idea. In the past, I may have made a contribution to society for "free." Well, not exactly for free; but because I knew that my contribution would be noticed and reciprocated. But as my community grows, it becomes increasingly difficult for people to keep track of each other's contributions. Well, if that's the case, then it might make sense to record my gift in some other manner. Accepting a monetary object is one way to do this. The money in my possession constitutes information about my past contributions to society. In the language of Narayana Kocherlakota (currently president of the Minneapolis Fed), money is memory.

Because commodities (including the physical capital that may back paper money) have uses in consumption and production, an implication of this is that society must bear a cost if such goods are tied up in facilitating exchanges. Their value in exchange generally means that they are priced above their "fundamental" value; that is, they possess a "liquidity premium." (This is related to what Caballero calls an asset shortage.)

Now, here is where fiat money potentially plays a role. According to the theory described above, the role of money is to encode a particular type of information (relating to individual trading histories). But information like a credit history is intrinsically useless (one cannot eat someone's credit history, for example). So rather than tying up intrinsically useful commodities to record intrinsically useless information, why not delegate the job to an intrinsically useless asset instead? Like the U.S. paper dollar, for example. (Electronic book-entry objects can work as well.)

According to this view, the market value of fiat money consists exclusively of a liquidity premium. The asset has no intrinsic value, and yet it has a positive price. Fiat money is a "bubble" asset -- but this is a bubble that plays a useful social role (it economizes on commodities that have uses other than record-keeping).

Prior to Ostroy's work, the answer to the question of how fiat money can possess exchange value was that its value is somehow supported by government decree (the original meaning of the word "fiat"). In particular, the government could introduce paper and insist that taxes be paid in government paper.

Evidently, it is the case that the Somali shilling continues to circulate in that country long after the government that issued that paper collapsed in 1991. Here is a quote from the paper:

One of the most astounding phenomena of the domestic market is the continued circulation of the old Somali bank notes. The Somali currency has had no central bank to back it up since the bank was destroyed and looted in 1991. Nonetheless,the currency has maintained value, and has floated against other foreign currencies that are traded freely in local markets.

One reason the shilling continues to maintain its value is no doubt related to the fact that it's supply can be trusted to remain relatively constant over time. In fact, it's supply may be contracting over time as notes wear out (I have heard stories of where old notes are laminated to make them more durable, but am unable to confirm this.) On the other hand, there is some evidence of counterfeiting; e.g.,

Perhaps the most convincing evidence that the Somali shilling held a positive value in the absence of sovereign support, however, is that individuals found it profitable to counterfeit these notes. Mohammed Farah Aideed ordered roughly 165 billion Somali shillings in 1996 from the British American Banknote Company based in Ottawa, Canada. Another 60 billion Somali shillings were imported by Mogadishu businessmen in 2001. In total, an estimated 481 billion in unofficial Somali shilling notes have been printed since 1991.

This counterfeiting phenomenon, however, does not appear to be excessive; and, indeed, it probably plays some positive role in keeping the supply of shillings relatively stable.

Tuesday, August 9, 2011

Who's going to listen to a company whose name translates to "average and below average"? Jon Stewart.

In my previous post (Wonderland), I asked what sort of evidence justifies making public sport out of the major bond rating agencies and their role in the recent financial crisis. The type of sentiment I question was repeated the other day by Paul Krugman here; I quote:

And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.

The first thing we have to ask, of course, is what does a AAA rating actually mean? The only thing most people know is that AAA is the highest rating that agencies attach to bonds. But that's an ordinal statement; it does not necessarily imply "absolutely free of risk." Apart from death and taxes, there are no perfect guarantees in life.

The second thing we have to ask is what sort of risk are the ratings trying to measure. In a nutshell, they measure the risk that the terms of a contract are not fulfilled. They do not measure the liquidity risk associated possession of the asset (the major problem during the financial crisis). Note: by liquidity risk, I mean the ease with with one can dispose of an asset (or use it as collateral in a loan) over a short period of time, without the asset being ridiculously discounted in the market.

Now, there seems to be no question that in the depths of the crisis, a lot of MBS was treated as if it were toxic (it was heavily discounted). But as I said above, bond ratings do not (I do not think) measure liquidity risk. They measure things like, well, did the MBS actually deliver on the interest and principal that was expected?

It surprising how difficult it is to find out just how much of the outstanding MBS actually did end up as toxic waste. Paul Krugman seems to think it was a lot. So do a lot of other people. But where is the data?

I decided to ask Gary Gorton, who knows more than most about these matters. Here is how he replied to me:

Of the notional principal amount of AAA/Aaa subprime bonds issued in the years 2006, 2007 and 2008 (which is almost $2 trillion), the realized principal loss as of Feb 2011 is 17 basis points – almost nothing, but much higher than AAA/Aaa other stuff. Yes, I think the agencies are being treated unfairly by uninformed people. There are many other facts that are similar that are also inconsistent with the popular narrative of the crisis.

If this is true, it is indeed remarkable. The actual losses on these "toxic" products has been tiny. That is the type of risk that was being evaluated. (I might add that the losses on bank deposits during the great financial panics of the U.S. National Banking Era (1863-1913) were reportedly in the order of 50 basis points.)

Evidently, Gary has a PhD student working on this. I look forward to reading her findings (and reporting them here). Of course, if anyone out there has evidence relating to this question, I'd greatly appreciate hearing from you.

Update: August 10, 2011

Thanks to Jesse for this link to Bond Girl, who makes a lot of the same points (and more).

I also received this note from Don Brown (thanks, Don--I will investigate):

I cannot verify current loss=17bp figure, but it doesn't sound surprising to me. HOWEVER, that misses the point. There are significant losses to be taken on 05-07 vintage subprime, due to massive delinquencies. It will be on the order of 12-15% of the original amount of AAA subprime securities that FNMA/FHLMC bought. I encourage you to do your own original research to verify this, but as a quick back-of-the-envelope:

I know that agency portfolios were buying wide-window AAAs off subprime, mostly 06-07 vintage. They bought a lot ($250B if I remember correctly). Note: portfolios were the hedge funds that FN/FH were running, outside of their traditional business as mortgage guarantor.

Average original subordination was 26-30%. So actual losses on subprime would have to be around this level to start showing losses. Currently, actual losses aren't at this level, but it's easy to see that they will increase (barring a miracle).

To date, most subprime deals have taken losses in the 15-20% range (percentage of original balance). They have serious delinquencies 40-60% of current balance (serious dlq defined as 90+ days dlq, FCL, or REO).

15% current losses leave you with 11-15% subordination (on average). Currently, subprime loss severity is around 80% (upon liquidation of the house). For a 50% dlq deal => 50%x80% = 40% additional losses from here (distributed over time). That would imply actual losses of 25-29% on the current face of the class. Average factor for these classes are 0.55. Very roughly, this translates to 12-16% loss on the original investment.

For examples, take a look at OOMLT 07-5 1A1(cusip 68403HAA0) and CWL 06-26 1A (cusip 12668HAA8). One of the agencies owns these classes (almost all subprime deals have a Group1 / Group2 structure. Group1 was conforming balance subprime loans that went to the agencies). You can find the remittance reports at BoNY web site or CTS. They are publically available.

Monday, August 8, 2011

For starters, I seem to find myself agreeing with Paul Krugman here: Credibility, Chutzpah and Debt. Well, except that it may not be as easy as he imagines to implement a sustainable fiscal policy, and I disagree with his laying the entire blame on an "extremist right." But what he says about the major ratings agencies may largely be true. Not that I can tell for sure...I am no expert in rating bonds. I'm not even sure about this claim (that I've heard repeated elsewhere):

And S&P, along with its sister rating agencies, played a major role in causing that crisis, by giving AAA ratings to mortgage-backed assets that have since turned into toxic waste.

I would very much like to know how many AAA rated MBS actually did turn toxic. Does anybody know? (Please send data, or links to estimates.)

I ask this because to some extent, I think that the bond rating agencies sometimes get a raw deal from public perception. It is my understanding (and I reiterate that I'm no expert) that what is being rated is the prospect of default on a set of debt covenants. While it may be true that MBS was treated as "toxic" by market participants (repo) during the crisis, this was more a "liquidity" event (perhaps based on the fear that some MBS were toxic, but not knowing the identity of which). As far as I can tell, bond ratings are not meant to capture liquidity risk. And perhaps most of that MBS continued to generate income. I'm just not sure how much of it did.

In any case, this takes me to the issue of the recent S&P downgrade of "long term" U.S. debt. The S&P statement can be found here.

Gosh, on the surface, the downgrade seems to be crazy. That is, the prospect of a nominal default seems remote; a real default (via surprise inflation) seems much more likely (though, this is not what is being rated). On the other hand, this is what a friend of mine had to say on the matter:

These ratings are educated opinions about how likely it is that holders of US debt will get their money back (including the yield). A AAA rating means it is basically a sure thing. AA- means there are conceivable, albeit not terribly likely, circumstances under which the funds will not materialize. This is not a direct comment on politics or the various reasons this event might happen. There are various reasons, including continued high spending, insufficient tax revenue, too little growth for the economy to pay the required taxes,... These are all lumped together in determining the rating. Of course, political types wish to point to their favorite reason, whether it is Democratic spending or Tea Party opposition to taxes. But don't let this confuse you. The point is simply that there is so much debt -- and it's growing -- that there is now real uncertainty about whether it can/will ever be paid.

What I find most interesting is the market reaction to recent events. First, I guess it's not too surprising to see how the price of gold has behaved recently; it has surged upward.

The "curiouser" part, however, is with respect to how the price of long-term U.S. debt has behaved. Here is a plot the price of Barcley's 20+ year U.S. bond fund.

Whoa! How do we make sense of the joint upward movement in the price of gold and (future) U.S. money; especially as the latter has just been downgraded?

The behavior of U.S. debt over the last few years has really intrigued me. Yes, the U.S. has a huge amount of outstanding debt out there. But you know what? The rest of the world seems to want it. Despite some bluster out there about replacing the USD (and US Treasuries) as the world reserve currency, I just don't see this happening any time soon. I know that a lot of people would like to see this happen. Might want to be careful what we wish for out there!

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